There are several important players in the U.S. securities market, including investors, full-service broker-dealers, retail broker-dealers that do not execute their own orders but rather route their order flow to other broker-dealers for execution (also referred to herein as order flow providers, or OFPs), broker-dealers that consolidate order flow from multiple OFPs (also referred to herein as wholesalers, or consolidating broker-dealers), and market-makers. It will be understood that, as used herein, the term “broker-dealer” refers to any entity that, when acting as a broker, executes orders on behalf of his client, and that executes trades for his firm's own account when acting as a dealer.
Generally speaking, investors drive the market by entering orders to buy or sell one or more securities. An investor may be, for example, an individual or an institution, such as a mutual fund or a corporation. The OFPs in the market aggregate investor buy/sell orders, and deliver these orders to one or more consolidating broker-dealers (acting as wholesalers) or to market making firms.
In order to provide liquidity in the market, one or more dealers agree to maintain firm bid and ask prices in one or more specific securities. These dealers, which are commonly referred to as “market-makers,” display bid and offer prices for these specific securities, and if these prices are met, will immediately buy for or sell from their own accounts. For example, almost every market (e.g., exchange, whether physical or virtual) where securities are traded has some form of market-maker that enters continuous two-sided quotations.
It is common for one or more market-makers on a given market to be provided significant responsibilities, including overseeing the opening, providing continuous quotations in all of their assigned securities, and handling customer orders that are not automatically executed in connection with that exchange. In the case of the U.S. equities and options exchanges, these market-makers, which are responsible for maintaining fair and orderly markets, are generally termed “specialists.” Depending on the particular exchange, the “specialist” may be referred to as, for example, a designated primary market-maker (DPM), lead market-maker (LMM), or primary market-maker (PMM), etc. Other market-makers in the crowd on an exchange floor, if any, are referred to as “floor market-makers.” For U.S. listed equities (e.g., stocks listed on the American Stock Exchange (AMEX) or the New York Stock Exchange (NYSE)), there are also firms that make markets off the exchange floor, and these firms are known as “over-the-counter” (OTC) market-makers or third market-makers.
Over the last half-century, the U.S. equities market has evolved into the widely accessible, efficient market we know today. This transformation has been driven, in part, by the demands of both retail and institutional investors for high quality and efficient trade execution.
Moreover, pricing efficiency in the U.S. equities market has benefited from various regulations that have been set forth by the Securities and Exchange Commission (SEC), the various securities exchanges, and the National Association of Securities Dealers (NASD), which is a self-regulatory organization (SRO) responsible for the operation and regulation of NASDAQ and over-the-counter markets. For example, a broker-dealer or market-maker must seek to obtain “best execution” (with order pricing being a significant factor) when handling a customer's equities order. In addition, there is a prohibition (subject to exceptions) in the listed equities markets against the practice of “trading-through,” in which a customer's order for an exchange listed equity is executed at a price inferior to the best available bid or offer. This trade-through prohibition does not apply, however, to NASDAQ listed equities. Moreover, under the SEC's “firm quote” rule, which is also subject to exceptions, a broker-dealer or market-maker is required to execute any equities order presented to it to buy or sell a security at a price at least as favorable to the buyer or seller as its published bid or offer, up to its published quotation size. These and other requirements help to ensure a relatively transparent equities market.
Existing SEC rules require all equity market centers (e.g., exchanges and broker-dealers acting as market-makers) to report data regarding the execution quality (e.g., speed, effective spread, trade-throughs) of their trades. These rules allow investors and broker-dealers to identify and avoid those market centers with a record of poor execution quality, in favor of those with better execution quality histories. In some circumstances, the broker-dealer community as a whole may seek to reduce (or completely eliminate) its exposure to a particular exchange, trading system, or market-maker in response to consistent execution of low quality (e.g., slow or mis-priced) trades by that market center. In such cases, even at times when that market center has a quote representing the “national-best-bid-or-offer” (NBBO), the other broker-dealers in the community may choose to internalize their trades (see below), if possible, or to route their orders to another venue.
FIG. 1 is a simplified illustration of one example of an order flow in the U.S. equities market. In general, as shown, investor 110 submits an order to buy or sell an equity (or equities) to OFP 120, which submits that order to wholesaler, or consolidating broker-dealer 130. In turn, consolidating broker-dealer 130 either internalizes the order (as explained below) or takes the order to an appropriate exchange of equities market 140 for execution. Equities market 140 shown in FIG. 1 may include, for example, the AMEX, the NYSE, NASDAQ (formerly referred to as the National Association of Securities Dealers Automated Quotation system), one or more electronic communications networks (ECNs), and one or more third market-makers. In equities market 140, publicly traded equities listed on one exchange can be traded, for example, on one or more regional stock exchanges (not shown), certain ECNs, and NASDAQ's SuperMontage system. It should also be noted that, with regard to NASDAQ (which is a competing dealer system and is currently not considered an “exchange”), consolidating broker-dealers can route orders in NASDAQ securities to NASDAQ's SuperMontage system, the NASD's Alternative Display Facility, ECNs, or specific NASDAQ market making firms.
In terms of fees associated with the order flow shown in FIG. 1, investor 110 pays OFP 120 a commission for executing his trade, while consolidating broker-dealer 130 pays OFP 120 for providing a given volume of order flow. The profit for consolidating broker-dealer 130, when internalizing the trade (as explained below), is made at the level of the trade execution, and is based on the spread between bid and offer prices for the equity (or equities) being bought or sold by investor 110. If consolidating broker-dealer 130 routes the order (e.g., to an exchange) for execution by another entity, however, consolidating broker-dealer 130 may receive some form of payment for the order flow (e.g., depending on the exchange that the order was routed to). When consolidating broker-dealer 130 is a full-service broker-dealer, for example, orders from investor 110 may be sent directly to consolidating broker-dealer 130 (which may then internalize the order or take the order to an appropriate exchange of equities market 140 for execution).
The concept of “trade execution quality” has emerged as a benchmark for investors to compare and contrast brokerage service providers along several dimensions, such as transaction costs, quote certainty, execution speed, price improvement, and market liquidity. In general, the growth of the investor community has placed continual pressure on service providers to improve execution quality along each of these dimensions.
The speed with which investor orders are filled in the U.S. equities market has benefited from the fact that broker-dealers who are OTC market-makers in listed equities and/or NASDAQ market-makers have the ability to “internalize” trades, in which they fill an order received from an OFP out of their own inventory in that equity. FIG. 2 is a simplified illustration of one example of an order flow in the U.S. equities market in which an order placed by investor 110 is internalized by consolidating broker-dealer 130. The ability of consolidating broker-dealer 130 to internalize a trade in the equities market affords it an opportunity to offer investors (such as investor 110) improved order execution speed. In addition, internalized orders have been known to receive some level of price improvement over the NBBO, with broker-dealers sometimes offering better fill prices to OFPs in exchange for a guaranteed level of trading volume.
Overall, the competitive landscape in the equities markets, along with the rapid expansion of internalization, have combined to provide investors with better execution quality along the price improvement and execution speed dimensions. For example, the equities market has progressed extremely rapidly over the last several years from ten-second trade execution guarantees to more recent guarantees of one-second executions, and at increasingly narrow bid/offer spreads.
As with equities, there is a very large market in the U.S. for the trading of options, which are financial instruments that are designed to provide the right, but not the obligation, to buy (for a call option) or sell (for a put option), for example, a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. Currently, listed options contracts can be traded on one or more of six national securities exchanges registered with the SEC. These exchanges are the AMEX, the Boston Options Exchange (BOX), the Chicago Board Options Exchange (CBOE), the International Securities Exchange (ISE), which is now the largest market for the trading of equity options, the Pacific Exchange (PCX), and the Philadelphia Stock Exchange (PHLX). The first four of these exchanges to come into existence, the AMEX, the CBOE, the PCX, and the PHLX, have traditionally used physical trading floors on which specialists and/or floor market-makers provide liquidity in assigned options classes, subject to certain affirmative and negative obligations. The ISE and the BOX, on the other hand, are both fully electronic options exchanges that began operating in the past few years largely following a demand for increased automation.
The U.S. options market also operates under SEC and exchange regulations regarding best execution and firm quotes, and is subject to rules designed to prevent trade-throughs (which generally includes filling an order at a price inferior to the NBBO). In order to determine the NBBO for an option contract, which may be trading on more than one exchange, it is necessary to gather information from potentially multiple exchanges. This is accomplished in the following manner. The Option Price Reporting Authority (“OPRA”) transmits quotations and trade reports from the options market to vendors for dissemination to the public. OPRA streams an NBBO data feed for the options market by aggregating the highest priced bid and lowest priced offer quoted at the time on all of the registered options exchanges. If two exchanges are quoting at the same price which would set the NBBO, the exchange quoting the larger number of contracts will be designated the NBBO. If the quotes have the same number of contracts as well, the first exchange to post the quote will be designated the NBBO.
FIG. 3 is a table 300 showing illustrative bids and offers received from various exchanges in connection with options contracts “XYZ” and “PDQ,” which are to be gathered and disseminated through OPRA. It will be understood that, when there is intra-exchange competition, each exchange will generally collect the individual quotes by its specialists and market-makers and send its best-bid-or-offer (BBO) to OPRA. OPRA then uses the various exchange BBOs to calculate the NBBO. With regard to options contract “XYZ,” it can be seen from table 300 that Exchange 1 provides the best (i.e., highest) bid of “40,” and also provides the best (i.e., lowest) offer of “41.” Accordingly, the best bid for “XYZ” is 40, and the best offer for “XYZ” is “41”. For options contract “PDQ,” meanwhile, it can be seen from table 300 that the best bid for “PDQ” is “17,” and the best offer for “PDQ” is “18.” To facilitate the reading of table 300, the best bids and offers (NBBO) for both “XYZ” and “PDQ” have been circled. It will be understood that the bids and offers provided in table 300, as well as the number of exchanges shown for each type of contract, are for illustrative purposes only.
The options intermarket “linkage” system provides specialists and floor market-makers with the ability to reach superior prices in other exchanges, and is designed to encourage efficient pricing and best execution for customer orders. FIG. 4 is a simplified illustration of the linkage system used to connect various exchanges in the U.S. options market. As shown in FIG. 4 (and mentioned above), the U.S. options market 440 includes the following exchanges: AMEX 442, BOX 443, CBOE 444, ISE 445, PCX 446, and PHLX 447. The NBBO is determined with regards to these options exchanges 442-447 as described above. The linkage system 450 provides certain participants in one market (exchange) with an automated means of obtaining access to better prices displayed in another market (exchange). When an order is routed to an exchange that is not displaying the NBBO, as explained in greater detail below, that exchange generally must either match the NBBO or transmit the order to the market that is quoting the superior price. An exchange that receives an incoming linkage order that represents an underlying customer order generally has fifteen seconds to either execute the order in whole or execute the order in part (e.g., when the incoming linkage order is larger than the “Firm Customer Quote Size”), cancel the rest, and move its displayed quotation to an inferior price. As also shown in FIG. 4, linkage system 450 uses telecommunication links 461-466. It will be understood that these links may operate using any of a number of known electronic data exchange mechanisms, including local and wide area networks, optical cable connections, dial-up telephone connections, the Internet, etc., and may be wire or wireless based.
The linkage system requires exchanges to avoid executing trades at prices inferior to the best available prices (e.g., “trade-throughs”), as represented by the NBBO disseminated by OPRA. For example, if an exchange that receives an investor's order through an automatic execution system, or electronic order routing system, is at the NBBO, the order will generally be automatically executed at the NBBO (assuming the order is for a number of contracts less than a threshold quantity), with the specialist receiving a certain share of the order based on the exchange rules. However, if the investor's order is routed to an exchange that is not at the NBBO (e.g., because the exchange receiving the order is faster or offers greater certainty of execution than other markets), generally speaking, that exchange must either “step up” and at least match the NBBO or route the order away to another exchange that is displaying the NBBO. Assuming the order is not routed away, it is possible for the specialist (or other type of market-maker, if the exchange permits) to “step up” and fill up to 100% of the order at the NBBO.
It should be noted, however, that the linkage system does not prohibit trade-throughs in all cases, but requires that market participants avoid initiating trade-throughs unless one of a list of SEC-approved exceptions applies (e.g., in the case of “fast” or otherwise unusually volatile market conditions). In fact, the wide-spread invocation of such exceptions to the firm quote and trade-through rules has created a difficult environment for market participants seeking to provide better execution quality for customers.
FIG. 5 is a simplified illustration of one example of an order flow in the options market. As shown, investor 510 submits an order to buy or sell one or more options contracts to OFP 520, which submits that order to a wholesaler, or consolidating broker-dealer 530. In turn, consolidating broker-dealer 530 checks the NBBO (which is determined, for example, as described above), as well as the exchange(s) on which the order may potentially be executed. Based on its duty to seek to obtain best execution for investor 510, broker-dealer 530 takes the order to an appropriate exchange of options market 540 (which includes, for example, the exchanges associated with options market 440 shown in FIG. 4 and described above) for execution. If the order is routed to a floor-based exchange, and, for example, is not eligible for automatic execution or is represented by a floor broker, it will generally be exposed to a physical auction on the exchange floor. In this case, the order will finally be filled by the specialist and floor market-makers based upon exchange-specific priority rules. However, this process may take, for example, between ten to fifteen seconds, and even up to several minutes, to complete. Alternatively, if the order is routed to a purely electronic exchange, a more rapid electronic auction and filling process occurs. However, the requirements of linkage can introduce delay into this process as well, as some orders may be required to be routed to floor-based exchanges in order to avoid a trade-through (execution at a price inferior to the NBBO).
In terms of fees associated with the order flow shown in FIG. 5, investor 510 pays OFP 520 a commission for executing his trade, while consolidating broker-dealer 530 pays OFP 520 for providing a given volume of order flow. When consolidating broker-dealer 530 simply takes the order from OFP 520 and routes it to an exchange, it generally receives some form of payment from the exchange. If a market-maker (e.g., specialist) that is associated with consolidating broker-dealer 530 handles the order on the exchange, however, the profit for consolidating broker-dealer 530 may be at least partially based on the spread between bid and offer prices for the option contract. It is possible for OFP 520 to be bypassed by investor 510, and, for example, for the order to be provided directly to a full-service broker-dealer for execution.
There are important differences between the U.S. options and equities markets which have the potential to reduce the execution quality available to investors in listed options contracts. For example, U.S. options broker-dealers cannot internalize trades (fill orders received from their own inventory of options contracts) in the same way that equity broker-dealers can. In particular, the rules of the Options Clearing Corporation (which is the issuer of all listed options contracts in the U.S. options market) require that all transactions in listed options take place through the facilities of an exchange. Accordingly, it is not possible for an options broker-dealer to perform, for example, an “upstairs” or “over-the-counter” transaction in a listed options contract. Rather, options broker-dealers can internalize a trade only after certain conditions have been met. For example, in the case of a “facilitation cross,” a broker-dealer may execute a customer order as principal only after the order has been exposed to the market via an auction process. This auction allows members of the crowd on that exchange to participate in the trade at the proposed or an improved price. The broker-dealer is only entitled to trade with the customer (by crossing the customer's order and the order for the firm's own account) after other better-priced quotes and public orders have been filled. In the equity markets, no such market exposure need take place, where “upstairs” block trading by a broker-dealer, for example, is permissible.
As explained above, SEC rules require equity market centers (e.g., exchanges and broker-dealers acting as market-makers) to report data regarding the execution quality of their trades. However, in the options markets, there are no universally accepted metrics for reporting execution quality, and as a result, there are no regulations requiring that such data be reported. This makes it very difficult for investors or broker-dealers to discourage certain behaviors of, for example, an offending specialist on an exchange (e.g., by taking their business to an exchange that has a record of better execution quality).
Several innovations have been introduced in the past by options market participants to try to improve execution quality. One such development, intended to improve execution speed, has been the expansion of automated trading systems onto the original floor-based exchanges. A specific example of this is the growing prevalence of automatic execution (“auto-ex”) systems for executing relatively small orders quickly and efficiently. Under such systems, orders routed to an exchange involving fewer than a threshold number of contracts may be tagged as “auto-ex” eligible, and will be executed at the prevailing bid/offer (the exchange's disseminated price) without exposure to auction on the exchange floor. The disseminated price on most floor-based exchanges is typically a specialist's “auto-quote,” which is updated based on characteristics of the option (e.g., volatility, interest rate, dividend).
Other efforts have been made to improve option order execution quality along the speed dimension, such as the development of “pseudo-internalization” methods, as described in commonly owned U.S. Provisional Patent Application No. 60/613,793, titled “Computer Implemented and/or Assisted Methods and Systems For Providing Guaranteed, Specified and/or Predetermined Execution Prices in a Guaranteed, Specified, and/or Predetermined Timeframe on the Purchase or Sale of, For Example, Listed Options” and filed on Sep. 27, 2004, which is hereby incorporated by reference herein in its entirety. As described in greater detail below, the concept of pseudo-internalization involves the use of, for example, a group of affiliated market-makers that together are able to provide options orders with a guaranteed order execution price and/or a guaranteed order execution time-frame.
On another front, floor-based exchanges are also developing hybrid electronic trading systems to improve execution quality along the pricing dimension by encouraging quote competition. This is an effort to move closer to the electronic exchange model, in which multiple parties (e.g., specialists and market-makers) compete to set an exchange's BBO level. For example, the CBOE Hybrid Trading Platform, which was introduced in 2003, allows specialists (referred to on that exchange as DPMs) and market-makers to electronically submit quotes for certain (but not all) designated option classes. These quotes, taken together with electronically submitted floor broker bids submitted on behalf of customers, are aggregated to determine the CBOE's BBO. This provides a similar competitive quotation result to the all-electronic ISE. The PCX Hybrid Trading Platform, also introduced in 2003, is very similar.
On the electronic exchange front, there have also been efforts to improve execution quality along the pricing dimension. The Boston Options Exchange (BOX) has implemented an electronic trading mechanism referred to as the Price Improvement Period (PIP) which is described in WO/2004/042514 to Peterffy, published May 21, 2004, and is hereby incorporated by reference herein in its entirety. Moreover, the ISE recently proposed to implement an electronic trading mechanism referred to as the Price Improvement Mechanism (PIM). A description of the ISE's proposed PIM is available at http://www.sec.gov/rules/sro/ise/34-49323.pdf, which is also incorporated herein by reference in its entirety.
Additional efforts to improve the trading of options and other securities are also described in the following published U.S. patent applications, which are hereby incorporated by reference herein in their entirety: U.S. patent application Ser. No. 09/841,388 to Adatia (Publication No. US 2002/0156716), published Oct. 24, 2002; U.S. patent application Ser. No. 09/896,061 to Schmitz et al. (Publication No. US 2003/0004858), published Jan. 2, 2003; U.S. patent application Ser. No. 10/246,562 to Muckwalter et al. (Publication No. US 2003/0177085), published Sep. 18, 2002; and U.S. patent application Ser. No. 10/623,434 to Zhou et al. (Publication No. US 2004/0024689), published Feb. 5, 2004.
With the improvements in execution quality offered by consolidating broker-dealers in the options market, however, has come increased risk to those same broker-dealers of exploitation by professional traders. These professional traders often possess (and seek to profit from) knowledge not available to the general investing public about the true underlying value of an options contract, as well as where the price of the options contract will (or is likely to) move in the near future. This is in contrast to standard traders, who are more likely to trade based on pure speculation, publicly available information, and/or liquidity or hedging needs, for example, and are thus less likely to have the information necessary to capitalize on “toxic” orders (which generally refers to orders that, if accepted by a consolidating broker-dealer, would result in no profit, reduced profit and/or a loss to the broker-dealer and/or an affiliate of the broker-dealer). Stated another way, an order for an options contract is said to be toxic from the standpoint of a consolidating broker-dealer when it is asked to supply market liquidity (i.e., to buy or sell) in situations where it makes no profit, reduced profit and/or indeed takes a loss on the trade.
An example of the potential ramifications of trading on a toxic order is now provided. Referring again to FIG. 5, assume that consolidating broker-dealer 530 is associated with a specialist in XYZ options contracts on the ISE (in this case, the specialist is referred to as a PMM). Moreover, assume that the bid price on XYZ call options is falling rapidly in real time due to recently released news about the company, and that the NBBO bid of “40” for XYZ (as shown in table 300 of FIG. 3) is actually a stale bid displayed by one of the manual options exchanges (with the theoretical fair value of the option having dropped to “38”). This stale bid situation may arise, for example, when an exchange specialist claims exceptions from the specialist's firm quote obligations (in order to delay trade execution until conditions are more favorable or to not fill the order at all), and the exchange is slow to update its quotes to reflect market developments. If the PMM associated with consolidating broker-dealer 530 is bound by a rapid execution guarantee and has agreed to always “step up” to the NBBO, a professional trader would see this quote-value discrepancy and be able to exploit the rapid execution guarantee by forcing the PMM affiliated with consolidating broker-dealer 530 to buy at “40” (to match the NBBO) even though the PMM was bidding at a lower price and, in fact, thinks the contract is only worth “38.” The trader is thus able to earn a potentially sizable profit, while consolidating broker-dealer 530 and/or its associated PMM is forced to absorb the loss due to the toxic order.
Moreover, consolidating broker-dealer 530 and/or an associated market-maker (e.g., specialist) may be forced to absorb a loss on a toxic order even when a rapid execution guarantee is not being provided. For example, consider a situation where a professional trader has knowledge (e.g., insider information) suggesting that the theoretical fair value (e.g., the value to which the price is likely to move in the near future) of an XYZ options contract is lower than the current NBBO price. In this case, the professional trader will be more likely than a standard trader to sell at the NBBO price (which would likely result in a toxic order and a loss for consolidating broker-dealer 530), and will also be more likely than a standard trader to refuse to buy at the NBBO price (which would likely result in a profit for consolidating broker-dealer 530).
As a consolidating broker-dealer, whether or not it is offering a rapid execution guarantee, is generally more likely to receive toxic orders from professional traders than from standard traders, the broker-dealer will generally be able to earn higher profits (or at worst break-even) over time by trading with standard traders. In light of this, a consolidating broker-dealer (particularly one offering an execution-speed guarantee) would be willing to pay for the privilege of trading with standard traders, if it were feasible to identify them. It would therefore be desirable to provide a system and method which would allow a market participant to detect and track the level of orders in a given option contract order flow that are likely to be, or in fact are, “toxic” versus the orders that are likely to be, or in fact are, “non-toxic.” Moreover, an ideal system would allow the market participant to respond to the nature of that order flow by, for example, rewarding a trading party (e.g., an OFP or an investor) for providing a less “toxic” option contract order flow.